West Texas Intermediate wanes as oil benchmark

A lingering gap between the prices of West Texas Intermediate crude and oil produced elsewhere is complicating the reliability of the longtime benchmark as the standard for pricing a barrel of black gold.

In a key signal, the U.S. Energy Information Administration announced last year that it would begin using international benchmark Brent crude instead of West Texas Intermediate as the reference price for light, sweet crude in its 2013 Energy Outlook.

The agency said it made the change mostly because retail gasoline prices, based largely on the price of crude, more closely track market fluctuations for Brent than West Texas Intermediate.

More broadly, however, anomalies in the U.S. market have made domestic oil less significant than Brent in reflecting how the market defines the always volatile “price of oil,” leading investment dollars toward Brent and away from West Texas Intermediate.

“For years, when someone said ‘what is the price of oil,’ the price quoted was WTI,” said David Knapp, an economist for the Energy Intelligence Group, a research company. “It was the definitive world price for crude. Now Brent is sharing the spotlight and is winning.”

Beyond the motorist at the pump, the price of crude is central to the profits and planning of oil companies, refiners, manufacturers and financial interests around the world.

Brent, a blend of crude produced in the North Sea, is traded on the London-based ICE Futures Europe Exchange. West Texas Intermediate, produced in Texas and Oklahoma, is priced according to futures trading on the New York Mercantile Exchange.

A futures contract is an agreement between a seller and buyer for delivery of crude at a specified price, date and place.

Both light and sweet

Brent and West Texas Intermediate both are graded as light, sweet crude, meaning they have lower density and sulfur content than some other types of oil. But West Texas Intermediate is of higher quality and historically traded at slightly higher prices than Brent.

But since late in the last decade, Brent has sometimes traded more than $25 a barrel higher. In January, Brent averaged $112.35 per barrel and West Texas Intermediate averaged $94.83, according to the Energy Information Administration.

The price difference stems at least partly from increased U.S. shale oil production combined with pipeline limitations and tight storage capacity at Cushing, Okla. A pipeline hub there is the physical delivery point for West Texas Intermediate specified in one-month futures contracts that set the U.S. benchmark.

The backup caused by transportation and storage constraints creates a glut that depresses West Texas Intermediate’s price – in some cases below that of similar oil delivered elsewhere in the U.S.

But other variables also figure in the equation and stand to maintain West Texas Intermediate’s price volatility even as the nation adds oil transportation capacity.

“Oil prices are reflective of many different things – the quality of oil compared to other oil, the value that refineries see when they refine that oil, as well as differences in transportation,” said Amy Myers Jaffe, executive director for Energy and Sustainability at University of California, Davis.

Besides the domestic boom, another factor in West Texas Intermediate’s discount to Brent is a long-standing U.S. government ban on exportation of domestic crude. While domestic production of sweet crude oil has increased, U.S. refineries are set up to process lower grade imported crude, and are still doing so, while stores of domestic crude rise.

The export ban effectively eliminates refineries in other markets as customers for America’s light, sweet oil, and that will keep it at a lower price than Brent, said James Sullivan, an energy analyst with Alembic Global Advisors.

Refineries can retrofit their systems to take better advantage of domestic oil, but it’s a costly investment that takes time, leading to predictions that the spread between U.S. and international prices could last years.

Inexact and volatile

The oil market itself is inexact and volatile – which is why thousands of futures contracts are executed daily, as traders make different bets on where the price will go and by how much.

Goldman Sachs, for example, forecast earlier this month that the price gap will narrow to $5 within six months. Other major players say it will be as high as $12 throughout the year.

These differences of opinion can influence price movements beyond market fundamentals of supply and demand.

“People have imperfect information, and so they can’t be rational,” Jaffe said.

Knapp, of the Energy Intelligence Group, said international investors who include crude futures contracts in their portfolios have been moving from West Texas Intermediate to Brent, further pushing up Brent prices.

But some energy economists argue that disparities between U.S. and international crude prices only reflect transportation costs.

“The commodity itself is fungible, and apart from differences in grades, the difference is just in the cost of transportation,” said Ed Hirs, an energy economics professor at the University of Houston.

Infrastructure improvements, such as the recent expansion of the 500-mile Seaway pipeline and the proposed Keystone XL pipeline, will ease some bottlenecks, but other factors will continue to affect the price spread between Brent and West Texas Intermediate.

International crises and supply scares, for example, typically put more upward pressure on prices for Brent than for West Texas Intermediate.

Reasons for concern

“Brent is an international crude, inflated by geopolitical concerns,” Knapp said. “We had Libya, the Iranian situation, now Syria and Algeria. There will always be a rich menu of reasons to be concerned about the security of oil, even though the oil keeps flowing.”

Oil and gas drillers operating domestically are watching the spread closely, hoping that transportation improvements will help boost the price of West Texas Intermediate and their profits.

“Brent is the world price,” said Steven Farris, CEO of Houston-based Apache Corp., in discussing commodity prices during a conference call on the company’s financial results this month.

He predicted that the spread between Brent and West Texas Intermediate will narrow.

But Jaffe is reluctant to make such predictions.

“The way the oil market functions, more than any other commodity, has this element of irrationality that is hard to predict,” Jaffe said. “There is so much of a risk premium on the price of oil that has nothing to do with the supply and demand and quality of the oil.”